Homebuilders: Short or Steer Clear?

Includes: KB, KBH, MHO, MTH, RYL, TOL
by: Adam Sharp

KB Homes (NYSE:KBH) missed big on Friday, reporting an $.87 per share loss. Their outlook on the market wasn’t rosy either. They dropped 8.5%. Builders appear to be a good short candidate. But like most industries, one needs to consider government interventions before shorting.

Major HB names are still up more than 100% from their 52-week lows. Kinda makes the S&P 500’s rally look meek:

  1. Meritage Homes (NYSE:MTH) up 307%
  2. M/I Homes (NYSE:MHO) up 198%
  3. KB Home (KBH) up 145%
  4. Ryland (NYSE:RYL) – up 111%
  5. Toll Bros (NYSE:TOL) up 47%

Government Crutch

Since last Fall, when a depression seemed imminent, builders have clearly benefited from government-support. The big question is: How long can this last? The Fed claims to be planning their exit strategy. But they always add a disclaimer, “not too soon“. Meanwhile, the fundamental side has changed little.

Cheap mortgages are here to stay for an extended period. Bernanke and Geithner have made this clear. They will do all it takes to prevent (or postpone) a depression. Cheap rates will buoy builders, but enough? This is where the homebuyer-tax-credit comes in, acting as another gross distortion of markets. Think about those people who bought a day/week/month before the credit passed. “Oh, gosh. You bought your home yesterday? Too bad.”

$8,000 Credit: Double and Expand It, Please

The first-time home buyer credit is scheduled to expire in November. But lobbyists are fighting hard to get it renewed. Congress seems likely to bite, despite our huge deficits. These market-interventions will largely determine the direction of home-builder stocks over the next year plus.

Sen. Johnny Isakson of Georgia, an ex-realtor, has proposed not only extending the credit, but expanding it to a max of $15,000. And he thinks everyone should be eligible in 2010; not just first-time buyers (WaPo). Bailouts and moral hazards don’t show any sign of abating.

So while the administration is under (a little) pressure to shrink deficits, more bailouts will probably pass. Our economic leadership views these market-distorting actions as victimless. Everyone benefits from rising home prices, right? Wrong. What about the millions of renters who are going to face higher taxes, due to drops in tax revenue? And what about responsible savers who have been waiting for homes to drop into their price range? They get screwed.

The Dreaded Spillover Effect

There would be a spillover effect on the broader economy if housing prices dropped. But do we really want to return to the days when houses were ATMs? Clearly that’s not sustainable. And despite falling prices, house valuation ratios remain out-of-whack. In a recent piece titled Falling House Prices Are The Solution, Not The Problem Patrick Killelea wrote:

It’s still much cheaper to rent than to own the same size and quality house, in the same school district. On the coasts, yearly rents are less than 3% of purchase price and mortgage rates are 6%, so it costs twice as much to borrow money to buy a house than it does to borrow (rent) the house itself. Worse, total owner costs including taxes, maintenance, and insurance come to about 9% of purchase price, which is three times the cost of renting. Buying a house is still a very bad deal for the buyer on the coasts, but it does make sense to buy in Michigan and some other places where prices have fallen into line with salaries and rents.

Shifting to a non-supported housing market too quickly would have negative effects. But we need to let housing prices fall much more than we have. It’s important to remember that we are fighting fundamental market forces here. Even the US government can’t really “win”. Something’s gotta give, someone has to lose. Let banks take the hit. They benefited from low interest for long-enough.

In short: For the immediate future, I won’t be shorting homebuilders. Too risky while all this cheap money is flowing. But I’ll be watching them, especially MHO, KBH, and MTH.

Disclosure: No positions in any companies mentioned
Disclaimer: None of this information should be treated as investment advice. Always consult a professional.